Weekend reading: Rebalancing portfolios in the real world

What caught my eye this week.

Two diligent bloggers took a run at the subject of rebalancing portfolios this week.

First up – in a tour de force that could give our own @TA a run for his carefully husbanded money – Occam Investing dove deep into the fabled ‘rebalancing bonus’, where investors see extra returns from regularly rejigging their asset allocation.

The post concludes that while such a rebalancing windfall is obviously welcome, the bonus cannot be banked on in the real-world:

Am I personally likely to benefit from the rebalancing bonus over the long term?

Probably not.

I’m not confident it’s possible to forecast anything with a great level of accuracy in markets, let alone being able to predict correlations, returns, and volatility. I’m certainly not confident enough to start making my portfolio more complicated by splitting it up, and therefore increasing trading costs, time required for monitoring, and risk of tinkering.

I may be sacrificing a potential rebalancing bonus by investing in a global tracker because I can’t rebalance its constituent parts.

But in my view, the benefits of a global tracker are worth it.

Not so well endowed

Funnily enough, this very same week on a A Wealth of Common Sense, Ben Carlson spotted the rebalancing bonus roaming in the wild.

After showing how a simple portfolio of index-tracking ETFs would have beaten the returns of a bunch of sophisticated endowment funds over the past decade, Ben noticed that an investor with an 80/20 stock/bond split across three particular Vanguard tracker funds could have conjured up even higher returns by annually rebalancing:

If you were to simply multiply the weights for the 80/20 portfolio (48% U.S. stocks, 32% int’l stocks, 20% bonds) by [their] returns you would get an overall annual return of 8.9%.

But the actual 10 year annual return for the 80/20 portfolio shows 9.1%.

How could this be?

The difference here is the rebalancing bonus.

Both authors show their workings, and both are well worth a read.

Everything in moderation

While any investor would take bonus returns where they can get them, rebalancing is best thought of as a risk management tool rather than a source of alpha.

You may or may not see a rebalancing bonus in your years as an investor. That’s down to the luck of the historical draw.

But you might well expect to have a lower-risk portfolio if you keep your allocations broadly in-line with where you’ve determined they should be.

As a naughty active investor, my portfolio is to a passive 60/40 set-up what quantum mechanics is to Newtonian physics. Investments pop in and out of existence in my portfolio all the time. Any one of them could affect my returns (for good or ill) much more than the modest impact of annually rebalancing between asset classes.

Nevertheless, these days I too try to ensure nothing grows too far out of whack. This can mean trimming winning positions, which I do knowing full well this can be a behavioural bias and mathematical blunder that curbs long-term returns.

So why do it?

Because you never really see a catastrophic blow-up in investing that doesn’t involve over-exposure to a share, sector, geography, or asset class.

Stay vaguely diversified and the worst you will likely do is relatively poorly.

Of course we all hope to do better than that! But avoiding disaster is the number one rule.

As Warren Buffett’s sidekick Charlie Munger says: “All I want to know is where I’m going to die, so I’ll never go there.”

Amen to that!

From Monevator

The 22 maxims of Sir John Templeton – Monevator

Bond credit risk valuation rule-of-thumb – Monevator

From the archive-ator: How gold is taxed – Monevator


Note: Some links are Google search results – in PC/desktop view you can click to read the piece without being a paid subscriber. Try privacy/incognito mode to avoid cookies. Consider subscribing if you read them a lot!1

Pandemic fuels broadest global house price boom in two decades [Search result]FT

…but UK housing boom cools as stamp duty holiday winds down – Guardian

HMRC closes unit set up to investigate family investment companies [Search result]FT

…but half a million UK partners and sole traders face bigger tax bills in 2022 [Search result]FT

Indexing has saved US investors £357 billion since 1996 – T.E.B.I.

Products and services

Five-year mortgage rates drop below 1%. Time to fix? – Which

Hostages of sky-high service charges – ThisIsMoney

FSCS to review its website after savers’ complaints [Search result]FT

China’s heavy hand in emerging market ETFs – ETF.com

Sign-up to Freetrade via my link and we can both get a free share worth between £3 and £200 – Freetrade

A look under the hood of Vanguard’s world tracker funds – The Escape Artist

Homes for sale with summer houses, in pictures – Guardian

Comment and opinion

Salaried – Indeedably

Get off my lawn! – Slightly Early Retirement

The cost of friendship – Incognito Money Scribe

Playing with FIRE: The millennial movement to quit work [Video]BBC

Nobody wants money – Breaking the Market

Sleeping on expensive financial pillows – Investing Caffeine

A life of meaning, without buying – Zen Habits

My investing nightmare – Of Dollars and Data

An interview with Carl Richards, aka ‘Sketch Guy’ [Podcast]Morningstar

Naughty corner: Active antics

Howard Marks goes all macro… [PDF newsletter]Oaktree Capital

Interesting stuff they don’t teach financial advisors in books – Josh Brown

The benefits of sin stocks – Alpha Architect

How the crypto market really works [Podcast] – OddLots via Stitcher

Do institutions or individuals win in the battle for alpha? – Larry Swedroe

Just like people, companies need cash to best survive black swan events – Klement on Investing

What’s the point of hedge funds? – Verdad

Covid corner

Covid infection level in England falls to one in 75 people – Guardian

The surprise dip in Covid cases in UK baffles researchers – Nature

Fifth of patients in hospital with Covid are young adults – BBC

An ICU doctor despairs of those who avoid vaccination – HuffPost

Kindle book bargains

The Moneyless Man: A Year of Freeconomic Living by Mark Boyle – £0.99 on Kindle

Hired: Six Months in Low-Wage Britain by James Bloodworth – £0.99 on Kindle

Happy Money by Ken Honda – £0.99 on Kindle

You Are a Badass at Making Money by Jen Sincero – £0.99 on Kindle

(Don’t have a Kindle? Buy one and join the cheap book club.)

Environmental factors

The six countries likeliest to survive societal collapse from climate change – Mic

Would you eat sushi made from tomatoes? [Video] – BusinessWeek via Twitter

Wildfires rage in the Med as climate change reaches Europe – via Twitter

Then the birds began to die – The Atlantic

Off our beat

The strange 19th-Century sport that was cooler than football – BBC

Blame the Bobos – The Atlantic

Other people’s mistakes – Morgan Housel

Putting in the reps – Banker on Fire

The truth about the quietest town in America – Wired

Fake political and vaccine news makes bad actors millions – Forbes

Apple is now an anti-fragile company – TidBits

Sell everything [Funny] – Litquidity via Twitter

And finally…

“The average investor is terrible at investing.”
– Tim Hale, Smarter Investing

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Bond credit risk valuation rule-of-thumb

There’s a rule-of-thumb you can use to evaluate when risky, higher-yielding bonds may be worth investing in.

Sadly the hour typically arrives when entering a market looks as suicidal as entering Deathtrap Dungeon in search of fame and fortune.

Apparent probability of death: Near certain!

We saw in part two of our Emerging Market bonds series that this sub-asset class’s historic outperformance has been driven by spikes in credit risk, following market hammerings.

Crisis-charged yields offered a profit opportunity to those who heeded Warren Buffett’s maxim: “Be fearful when others are greedy. Be greedy when others are fearful.”

So I asked hedge fund quant and Monevator reader ZXSpectrum48K if there’s a bond market signal that can help us recognise these decisive moments.

Beware all ye who enter here

Warning: what we’re about to discuss is a very rough rule-of-thumb. It is not an iron law of bonds, and you can have no expectation of profiting from it.

Think of this bond credit risk valuation method as analogous to the cyclically-adjusted P/E ratio (aka CAPE).

Its efficacy is highly debatable. It relies on mean-reversion to a historical ‘average’ that may not apply in the future.

You’ll also need considerable fortitude and spare financial firepower to burn if your judgement proves wrong.

With that said, let’s gird our loins and push into the dungeon’s maze.

Yield and spread

Yield and spread may sound like sweet-nothings whispered on a medieval speed-date but they’re actually the key metrics for ZX’s money.

That’s because his rule-of-thumb enables him to estimate the credit spread of a high-yield fund versus an appropriate benchmark, such as US$ Treasury bonds.

The credit spread compensates you for the default risk inherent in high-yield bonds.

A wide spread may mean the market is over-reacting to recent waves of defaults or anticipated risks. You’ll win if you invest when the credit spread runs ahead of the default rates that actually occur.

By comparing the spread against historic norms, you may get a sense of when to press deeper into the gloom in pursuit of treasure.

I’m going to leave out ZX’s maths and cut to the chase:

Step one: Find the yield-to-maturity (YTM) and duration of the high yield bond fund you’re interested in. These metrics should be published on the fund’s web page or factsheet.

Step two: Subtract the YTM of an equivalent duration US$ Treasury bond fund from your first bond fund’s YTM.

The difference in those yields is a reasonable approximation of the credit spread.

The wider the spread, the riskier your bonds are judged to be by the market.

If Buffett’s adage and market history holds then periods when the credit spread widens could herald an opportunity.

Note, you need to have some sense of historical credit spread fluctuations in your market.

Bond credit risk valuation in practice

Following on from our series on risky Emerging Market bonds, I looked at the iShares Emerging Markets Government Bond Index Fund.

It follows the market-leading index1 for EM US$ sovereign bonds, so is a useful proxy for that sub-asset class.

I’ll compare our fund with iShares $ Treasury Bond 7-10yr ETF. This is the closest duration match I can find among the available US Government bond funds.

Here’s the Emerging Market bond fund’s numbers:

Yield-to-Maturity (YTM): 4.09%

(iShares publishes the yield-to-worst for this fund but that’s close enough for our purposes.)

Modified duration: 7.77

Here’s the US$ Treasury fund’s numbers:

Yield-to-Maturity (YTM): 1.4%

Modified duration: 7.96

Approx credit spread = Credit risk bond fund yield minus US Treasury fund yield.

4.09 – 1.4 = 2.69%

How does 2.69% compare to the credit spread history of the EM US$ sovereign bond fund’s index?

This chart shows the index’s spread over US Treasuries:

The spread sank to an all-time low of 1.66% in May 2007. (That’s 166 ‘basis points’ in the chart above.)

2.69% is the tightest spread since January 2018.

What does that tell me, according to our rule of thumb?

It suggests this is probably not an auspicious time to load up on Emerging Market US$ sovereign bonds – at least on this metric.

Better bookmark this four-part series after all, and come back when the rule of thumb is flashing green!

Take it steady,

The Accumulator

The JP Morgan Emerging Market Bond Index Global Diversified.

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The 22 maxims of Sir John Templeton

When it comes to legendary investors, Sir John Templeton was a legend’s legend.

Templeton is immortalised as the man who brought international investing to North Americans. Touring the world in his twenties – still a racy thing to do eight decades ago, at least out of uniform – Templeton was one of the first to see the potential of Japan. He backed its firms to the hilt.

Later he did the same with the tiger economies of South East Asia.

Templeton’s winning career as a fund manager and stock picker in foreign markets is immortalized in names like the Templeton Emerging Markets Investment Trust.

But there are plenty of other reminders from John Templeton’s life that can teach us about finding success as an investor.

Templeton did things differently

The most famous of Templeton’s contrarian actions happened in 1939.

On the eve of the Second World War, when Templeton was all of 26-years old, he borrowed a then-massive $10,000. He had decided to buy 100 shares in each of 100 companies whose beaten-up stocks cost less than a $1.

Templeton judged the market was in headless chicken mode due to fears about the upcoming conflict. He wasn’t sure which shares would prosper. But he was convinced they were all trading out of whack.

The profits he banked when the markets recovered initiated a lifetime of running money.

Templeton had learned to read the emotional moods of markets by visiting cattle auctions during the Depression Era with a bargain-hungry older uncle. Perhaps economists would have quicker to get to behavioural economics if they’d spent less time with mathematical models and more time watching farmers yelling at each other!

Even with today’s knowledge though, it takes a rare mindset like Templeton’s to see opportunity on the cusp of a life-or-death conflagration.

Popping the bubble

Fast-forwarding 60 years, and Templeton was actively shorting the Dotcom Bubble. In his 80s! He was no perma-bullish Warren Buffett.

I’ve wondered before about the return sheets of the greatest old investors. Often there’s a presumption that their out-sized success comes courtesy of time and compound interest.

But to be actively betting against your grandkids’ smartest peers on Wall Street by shorting the most popular stocks – and winning – is something else.

What’s more, Templeton chose his targets in a cunning fashion. He studied the Dotcoms that had recently IPO-d, and looked for when the lock-in deals that restricted their freshly-minted founders from selling up would expire. Thus he anticipated who’d first dump their shares on the market. Kerching!

Man of mystery

Passing on little stories about Templeton’s profitable exploits matches how I learned about the man myself.

I’ve never read an investing book about Sir John Templeton, in stark contrast to my other favourite investors. (Templeton finally passed away at the grand old age of 95 in 2008).

Rather, I found out about Templeton through mentions in unrelated books, word of mouth, and magazines and websites.

That’s how I came across Templeton’s 22 maxims for investing success.

These pointers are most applicable to active investors trying to beat the market.

But there are also nuggets that passive investors should appreciate, too.


The 22 investing maxims of John Templeton

1. For all long-term investors, there is only one objective: ‘maximum total real return after taxes.’

2. Achieving a good record takes much study and work, and is a lot harder than most people think.

3. It is impossible to produce a superior performance unless you do something different from the majority.

4. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

5. To put ‘Maxim 4’ in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.

6.  To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.

7. Bear markets have always been temporary. Share prices turn upward from one to twelve months before the bottom of the business cycle.

8. If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and, when lost, won’t return for many years.

9. In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.

10. In free-enterprise nations, the earnings on stock market indexes fluctuate around the book value of the shares of the index.

11. If you buy the same securities as other people, you will have the same results as other people.

12. The time to buy a stock is when the short-term owners have finished their selling, and the time to sell a stock is often when the short-term owners have finished their buying.

13. Share prices fluctuate more widely than values. Therefore, index funds will never produce the best total return performance.

14. Too many investors focus on ‘outlook’ and ‘trend’. Therefore, more profit is made by focusing on value.

15. If you search worldwide, you will find more bargains and better bargains than by studying only one nation. Also, you gain the safety of diversification.

16. The fluctuation of share prices is roughly proportional to the square root of the price.

17. The time to sell an asset is when you have found a much better bargain to replace it.

18.  When any method for selecting stocks becomes popular, then switch to unpopular methods. As has been suggested in ‘Maxim 3’, too many investors can spoil any share-selection method or any market-timing formula.

19. Never adopt permanently any type of asset, or any selection method. Try to stay flexible, open-minded, and skeptical. Long-term results are achieved only by changing from popular to unpopular the types of securities you favor and your methods of selection.

20. The skill factor in selection is largest for the common-stock part of your investments.

21. The best performance is produced by a person, not a committee.

22. If you begin with prayer, you can think more clearly and make fewer stupid mistakes.

Want more? Compare Templeton’s maxims to the rules of Walter Schloss.

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